posted 9/10/12 - revised|
EARTHQUAKE INSURANCE -
TO BUY OR NOT TO BUY - THAT IS THE QUESTION!
any community associations have been inquiring whether they should buy earthquake insurance, considering that the costs have become exorbitant. After networking with attorneys all over the state of California that had to deal with the problems involving reconstruction, collection of special assessments, and disputes with insurance companies in the aftermath of the Loma Prieta and Northridge quakes, I feel it prudent to recommend that associations purchase earthquake insurance if they can get it, even if the price is high. Why? From what I was told, Associations that did not have earthquake coverage for the most part did not recover. Those who did have master coverage were usually able to rebuild. I first came to this conclusion a few years after Northridge Quake and started writing about it. My article has been distributed far and wide and it is my hope that if nothing else, the article helps boards and owners understand how to better analyze the difficult question of to buy or not to buy earthquake insurance.
I hear all too often that "they" (people who cannot seem to be identified) advise associations not to purchase the insurance because of the large deductibles and high cost. Some decree "If there is a big one, everyone is goin' down, so why buy!" That sounds like a defeatist (and uneducated) attitude. "Everybody" did not go down after the Northridge earthquake and it was a big one. Certainly, if your association has very low reserves, high delinquency rates, and considerable deferred maintenance, and the association members will have to come up with large sums to "stay afloat" in the coming years, paying money out for earthquake insurance will be a hard pill to swallow, maybe too big, but it is worth it to explore the options anyway.
Weighing the Pros and Cons of Earthquake Coverage: As for the cons, earthquake insurance is expensive. No one argues with that. But consider that not having it is quite a gamble. "No coverage" means in a devastating event, possibly having to raise enough money to pay the full cost of rebuilding, starting over with no proceeds and still having mortgages to pay! That's a double whammy. Any financial foundation provided by proceeds from a master policy would give an association a fighting chance to recover in the event of substantial damage. And if all or the bulk of owners were diligent and purchased the gap coverage now we are talking about an even better "foundation". By "gap" coverage I am talking about coverage to pay the individual's portion of the special assessment the association would have to assess to cover the deductible and any shortfalls, and this coverage is available through the CEA. A CEA policy also provides coverage for individuals to pay costs of rebuilding all fixtures and portions of the unit for which they are responsible for such as flooring, wall covering, paint, carpeting, move out or lost rent expenses, and personal property damage. In Northridge, associations that had shortfalls built back the "box" of the units and owners in many cases were left to add the fixtures, cupboards and all finishes. CEA money would have helped with this.
It's only fair to talk about the reality that some owners whose master plan is to "walk away" from their homes if the big one hits, and let the banks foreclose, for this too is an honest concern. If an association carries master earthquake coverage, all owners must share in the premiums, thus sharing in the price of balancing of the risk thus all owners have participated in laying the "foundation" to recovery. If an association has no master policy, those owners who plan to walk will avoid all responsibility toward protecting the association's financial health with protective coverage. Which seems the most fair, especially to the folks who have built up equity in their property? After the fact the association does have foreclosure rights and also personal debt action rights against owners who do not pay special assessments but as most know, it is not easy to collect debt these days. So why let these owners avoid the up-front participation in risk sharing?
How Does As Association Reconcile the Large Deductibles? One way is to be diligent about funding reserves. If there is serious building damage, reserves can add to the "foundation" for recovery, and once again this is a source of funds that all owners participate in. Another way is to encourage owners to purchase "gap" coverage through the CEA or whatever source is or becomes available. The more owners that add this extra level of protection for themselves, the larger the association's reconstruction "foundation" becomes, because those owners will be able to pay their share of the shortfall (which includes the deductible) almost immediately, via the earthquake "loss assessment" coverage. One of the first things the board will be doing is having the damages adjusted, figuring out whether rebuilding is possible and if so, what funds are available and what special assessment will be needed. Those owners who bought the extra protection will be able to pay their share right away, and avoid paying interest or loan fees, because that is the next consideration - loans. Some owners will need the assistance of a loan so they can pay over time and small business government and/or bank loans are commonly payable over a period of 5-7-10 years.
After Northridge, many associations needed to borrow and small business loans at a lower interest rate were made available. Thus, there are 3 layers to recovery, master coverage, individual coverage and payment of special assessments, and loans.
A board that presents a "program" geared to succeed if "the big one" hits is clearly doing important due diligence. If the majority of owners don't buy it, and owner approval is needed to approve a special assessment to pay for the coverage, then so be it. But getting good feedback from the owners is a "process". Education is extremely critical. Many owners do not know that neither the HO-6 condo owner policies nor the fire and casualty master policies cover earthquake damage.
Why Should The HOA Listen to Brokers or Lawyers? I have discussed with many boards and owners the considerations behind the decision whether to buy or not to buy earthquake insurance. I write about this subject a lot. I have been involved in meetings with other industry professionals and the CEA, in meetings to discuss insurance requirements and legislation with other industry leaders, and have "picked the brains" other attorneys whose clients experienced substantial challenges after earthquakes. I worked with a number of associations to complete the requirements for loans to repair earthquake damage. Many insurance brokers distribute my published articles to their clients so that boards will be educated on how to approach the question and how to explain the considerations to owners. This collective information is not readily available in a condensed format. Obviously, if a broker standing alone is encouraging earthquake insurance, someone is sure to point out that it is self-serving. But what is important is that boards have information on the policies available, what they cover, and what the deductible is and how it is applied for example building to building or overall. So it is important to listen to the brokers and agents with an open mind. The process of choosing earthquake insurance and planning for the best outcome is a process requiring considerable education on the risks and options.
Is Earthquake Insurance Required? Check the association governing documents. If the CC&Rs or Bylaws or underlying regulatory documents require the board to purchase earthquake insurance and the board does not, this invites trouble. The association and possibly the board members will be at a disadvantage there is a lawsuit filed over any units damaged by an earthquake. Why? The Board would be considered in breach of its fiduciary duty for ignoring the documentary requirements. If the governing documents do not require the purchase of earthquake insurance, and coverage is not obtained, and there is serious earthquake, likewise, the board and association might be sued. Perhaps a lack of "obligation" might be present a decent defense. It's hard to tell for sure. To date, there is no California case that I know of that dictates the outcome of such a lawsuit. Even so, if a board is advised it is on good legal standing to avoid earthquake insurance, there is still a downside. In any association where master insurance coverage for the buildings and units is required for fire and common casualties, but not earthquake, and no earthquake coverage is purchased, there is still the likelihood that there would be no insurance to defend the lawsuit either and the association would have to pay to defend out of pocket. This is an important factor. Most Directors and Officers liability coverage policies that are purchased to cover defense and damages for board acts and breach of fiduciary duty exclude the failure to insure as a covered claim. A board can check the D&O policy to see if this is the case, and factor this into the presentation to owners because it is they that would pay to defend. And such a lawsuit could cost a lot of money!
What is An Affordable Master Policy These Days? I can't tell any association what is affordable, especially in these economic times. I know what I am willing to spend but even that would not dictate how I should be thinking as a board member if I were serving and had to weigh in on the board decision. I can only say that as an attorney, I take the position that no board should be making the decision not to insure or dropping coverage without letting the owners weigh in, either by survey or ballot. The duty of a board is to take into consideration the interests of the community and not make decisions based on individual preferences. Many individual owners cannot figure out for themselves that there is a way to build a solid foundation upon which to rebuild. Many don't know that the difference between a special assessment of $15,000 and $150,000, or $30,000 and $300,000, or exponential increases (depending on the value of the property) depends on whether the association has master coverage. If they knew they might work on their neighbors and the naysayers. Any individual owner can obtain coverage for up to $75,000 through the CEA to cover loss assessments (which are special assessments to pay for rebuilding shortfalls.) The premiums for the individual coverage can be calculated on the CEA site.
What Should a Board Do? The answer is practice due diligence. Vet the questions and involve the owners in the decision. Many boards, when they face the question each year and especially when they see increases in cost and cuts in coverage, are discouraged. And if the focus becomes solely the cost, the board is missing the boat. Directors can lose their objectivity. They or their neighbor's plight sways them away from thinking in terms of what is best for the collective group of owners. It is extremely important to take certain steps before making the decision to buy or not to buy. At the least:
- 1. Consider what the governing documents require.
- 2. Obtain as many bids as you can for the insurance so you will have proper information to provide the owners information about what is available. An agent could provide his/her company's bid. A broker may have access to several different companies.
- 3. Determine whether the premium costs involved would require homeowner approval (i.e., if they are in excess of legal limits for increases in regular assessments or imposing a special assessment which in California is 20% a year for regular assessments and 5% of the budgeted gross operating expenses for the fiscal year for a special assessment per Civil Code Section 1366).
- 4. Do some research and consider obtaining a risk analysis for type of development and geological location. You can pay for such an assessment or get basic information from websites like http://earthquake.usgs.gov/, http://www.consrv.ca.gov/cgs/rghm /psha/Pages/index.aspx, http://www.homerisk.com/.html, and/or other sites on the web.
- 5. Peruse the CEA (California Earthquake Authority) website and gather and provide owners with information on what coverage is available and the limits and, if you really want to be thorough, on various premiums in a chart tied to coverage amount choices, and/or urge owners to explore the site (http://www.earthquakeauthority.com/).
- 6. Survey owners and ask where they stand. It is imperative to provide them with meaningful facts and information the board has gathered. Here are some pertinent questions for owners:
- a. Do you have an individual HO-6 policy and do you know that it does not
- b. Do you now or do you intend to purchase an earthquake policy through the CEA or any other source?
- c. Are you in favor of the association purchasing earthquake insurance?
- d. When did you purchase your home?
- e. Do you have plans to sell your unit within the next year?
- 7. Make a prudent decision after gathering and considering the information as described above to buy or not to buy, or to obtain owner approval if that is necessary or the route you choose.
Don't just say "NO", boards. Do the research, gather information from the owners, consider the options as well as the economical feasibility and the gravity of the potential problems both with and without the master policy, and share these with owners, and get their feedback.
Be honest about the risks of dropping it!
Those risks are:
- No coverage, no foundation to rebuild!
- If there is an earthquake, the board members and association could be sued and the directors and officers liability carrier might deny coverage for "failure to adequately insure" (depending on your D&O coverage).
- If the association has no coverage, and there is an earthquake, more owners will "walk away" and leave behind a trail of problems for those that stay and the problems are much harder to overcome if there is no preliminary "foundation" upon which to rebuild (the "foundation" being insurance proceeds).
- "Stand alone" coverage which is purportedly being offered for individual homeowners whose associations are uninsured is not a practical solution, considering how difficult it would be to rebuild one single unit in a four, five or six unit building.
Even if the association decides not to rebuild after an earthquake, there is some payout from the master insurance coverage and through the CEA coverage so this is another factor to consider and explain to owners. You may need the assistance of your insurance professional and/or attorney to be able to explain the coverages with or without rebuilding to owners.
If you could ask the homeowner survivors of Hurricanes Katrina, Isaac and those that had to rebuild after devastating tornadoes or fires if they wished they had purchased or were glad they had insurance, you can bet they would probably say yes, even if it did not cover 100% of the loss. Hindsight is always 20/20.
Voting Requirements. If your CC&Rs require that the board purchase earthquake insurance coverage, then it needs to be purchased unless the CC&Rs are amended. CC&Rs or other recorded regulatory documents commonly take 75% to amend and may require lender consent as well to drop insurance coverage. If the documents do not require the purchase of earthquake insurance, then the Board could (but is not necessarily required to) put the matter to a vote of members. If the measure (in California) is posed as voting on a special assessment to pay the cost of the premiums, a majority of a quorum approval is needed. Per Civil Code Section 1366 a quorum for this vote is a majority of owners. If a special assessment is not needed then the measure is in character a corporate action matter and the percentage of approval would probably be a majority of a quorum if there are more than 50 owners, but the quorum is based on the meeting quorum for the association. If there are less than 50 owners the approval requirement is probably half the owners. This is where it is important to have legal advice. The voting requirements in the law and the governing documents on this subject have to be reconciled.
Considerations of Retrofit: Some associations are considering using the money that would otherwise be used to purchase earthquake insurance for retrofitting. If your buildings could benefit greatly from retrofitting, this might be prudent option. However, the above considerations still apply because and unless you have the ability to retrofit before any earthquake (which no one can predict with certainty), the risks are the same. There are also ways to layer coverage to save money. A good broker can help with this. There might be a feasible way to combine the purchase of some level of coverage with some retrofitting. If the members of the association are willing to purchase individual policies a higher deductible might make sense. Considering hybrids would at least be something proactive.
In any event, the decision whether or not to purchase insurance, unless dictated by the governing documents, requires "due diligence" and a "prudent business decision-making". The things I have talked about above are factors. Be sure to consult with knowledgeable insurance providers and attorneys in gathering information. Non-HOA-experienced professionals often provide misleading information.
© By Beth A. Grimm, Attorney. A member of the Bay Area-Central CAI Chapter and CAI, past Public Relations Chair of the California Legislative Action Committee (CLAC), ECHO East Bay Resource Panel Chairperson, and author of FINDING THE KEY TO YOUR CASTLE, THE CONDO OWNERS HANDBOOK by Sourcebooks. THE DAVIS STIRLING ACT IN PLAIN ENGLISH, and other helpful community association publications. Visit other places on this website for more information.